Schwab Market Talk - November
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MARK RIEPE: Welcome, everyone, to Schwab Market Talk. Thanks for your time today. The date is November 15th, 2022. The information provided here is for informational purposes only and all expressions of opinion are subject to change without notice in reaction to shifting market conditions. My name is Mark Riepe. I head the Schwab Center for Financial Research, and I’ll be your moderator today.
For those of you who are new to these webcasts, we do them once a month. Many of you took the opportunity to submit questions during the registration process. We’re going to be trying to answer as many of those as we can in the first part of the webcast. And then for those of you who submit questions during the webcast, itself, we’ll focus on those in the second half after the webcast. But you can, of course, submit questions at any time. Just type the question into the Q&A box on your screen, click Submit, and, as I said, we’ll try to focus on those in the second half of the show.
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Our speakers today are Mike Townsend, our Managing Director of Legislative and Regulatory Affairs; Liz Ann Sonders, our Chief Investment Strategist; Jeffrey Kleintop, our Chief Global Strategist; and Kathy Jones, our Chief Fixed Income Strategist. We’re going to start out by talking about various things pertaining to the election in Washington, and we’ve got a few questions about the Fed. We’ve got about three or four questions about the international scene. And then we’ll shift to the economy, bond markets, and stock markets. And then as I mentioned, we’ll start answering live questions.
So, Mike, welcome back to the show. Why don’t we start off with you. I guess maybe we’ll just start out with a big obvious question. What did you really kind of take away from the election that matters most to investors?
MIKE TOWNSEND: Well, sure thing, and good morning, everybody. Great to be with you from Washington. You know, obviously, we’re still waiting for final results in some of the races after a fascinating election night that I think didn’t play out quite like a lot of people expected. We do know that the Democrats will retain their narrow majority in the Senate. We just don’t know if it’s going to be 51-49 or 50-50 until we get the results of the runoff election in Georgia on December 6th. And it appears that Republicans will have a small majority in the House of Representatives, likely by just a couple of seats. So with the likelihood of a split Congress and tiny majorities in both chambers, you know, that’s just not a recipe for getting a lot of big stuff done in 2023. I think it’s going to be really difficult to find issues which the two parties can compromise.
That said, though, I would point out that, you know, 2022 sort of proved us wrong, that, you know, even when we see bitter divides in Congress like we currently have, Congress does manage, though, to find a way to get things done. You know, in just the past year, Congress has passed a huge infrastructure bill, the first gun bill in more than two decades, a veterans healthcare bill, China competition bill that boosts the US semiconductor industry, and three bills to provide aid to Ukraine in its fight with Russia. All of those passed with bipartisan support. So maybe looking ahead things can get done.
I do think you’re going to see compromise next year on a bill to create a better regulatory structure for cryptocurrency, obviously, a hot topic in the wake of the implosion last week of the Crypto Exchange FTX. I also think energy permitting reform, maybe some antitrust steps to reign in some of the largest tech companies, those are some areas where we might see compromise in a divided Congress. But as I said, I think big sweeping bills are going to be really tough to come by.
So we’re kind of talking about gridlock, and, you know, as you know, Mark, the markets generally like gridlock.
And one other thing, Mark, that they like, the markets tend to like the year after a midterm election. In fact, the S&P 500 has risen in the 365 days following every midterm election since 1950. So that’s certainly a trend that I think we can all hope continues.
MARK: Mike, we’ve got… I guess now we’re technically in the lame-duck session. In the past you’ve talked about how this might be the best time to get the Secure Act 2.0 passed. In fact, we’ve already got a question about that. What do you think, is that still a possibility?
MIKE: I definitely think it’s a possibility. There is broad bipartisan support for a package of retirement savings changes that’s been percolating in Congress for much of this year. You go all the way back to last spring, Secure 2.0 passed the House by 414 to 5, which is about as bipartisan as you can get. The Senate has also strongly supported legislation on a bipartisan basis. Two different bills in the Senate have gotten unanimous support at the committee level.
What we’re watching now, Mark, is how some of the differences between the Senate and the House versions get resolved. Negotiations have been going on behind the scenes to find a compromise, because, ultimately, the House and Senate have to agree to the exact same legislation. Among the things that we’re watching, that both the House and Senate seek to raise the required minimum distribution age to 75, but they do so on different timelines. We do think there’s going to be an increase in the final bill, but we just don’t know exactly when that’s going to go into effect. We think it’s probably going to be delayed for a few years, so we’re kind of waiting for the details on that. Another example is that both bills would increase catch-up contributions for people approaching retirement age, but they differ slightly on exactly what that age is. So that’s another thing that’s going to have to be resolved. Also, lots of good stuff in this bill for employer-sponsored plans, 401(k) plans, and other things.
So, you know, I think there’s a lot of good things that both parties like in this legislation. The most likely scenario is that this gets attached to the big end of the year government funding bill that has a deadline of December 16th. So I think that’s probably the timing we’re looking at, mid-December before this gets resolved, but definitely worth keeping an eye on.
MARK: Another thing that’s going to come up next year is the federal government hitting the debt ceiling limit. Do you think this is something that will be addressed by the current lame-duck Congress or are they going to punt the ball to the new Congress? And I guess, most importantly, is this something that investors should be worried about?
MIKE: Well, I’ll take your second question first because that’s an easy one. Yes, absolutely, investors should be worried about that. You know, I think what’s interesting is that there does appear to be some momentum on the hill right now to try to resolve the debt ceiling before the end of the year. The reality is if you wait until next year in a split Congress, that’s going to be a really, really difficult fight. House Republicans have already said that they plan to use the debt ceiling to extract concessions on spending cuts and other issues from the White House. And, of course, President Biden has already come out and said he won’t be making any concessions with regards to the debt ceiling. So you kind of have the lines already being drawn. This has a lot of echoes of the fight of the summer of 2011. That’s when we came the closest that we ever came to defaulting on our debts. Market volatility spiked Standard & Poor’s actually downgraded US debt for the first time ever back in 2011. The markets don’t like uncertainty about when and whether Congress is going to raise the debt ceiling, and I think no one really wants to find out what happens if we were ever to go into default.
So I think what’s interesting is whether Democrats really take a shot at trying to raise or suspend the debt ceiling here before the end of the year. The idea, of course, would be to do it while they have control of both chambers before Republicans potentially take over the House in January. So the reason this is kind of getting attention right now is because House Speaker Nancy Pelosi, Senate Majority Leader Chuck Schumer, Treasury Secretary Janet Yellen have all publicly endorsed the idea of resolving it now.
Personally, I think it’s a heavy lift to get it done by mid-December, given how short the time is, given, you know, how much else is on the agenda, how politically tricky debt ceiling votes traditionally are. So it feels kind of like a long shot to me, but definitely worth watching. There’s no question, question that the markets would love to have this resolved before the end of the year.
MARK: Thanks Mike. Last question for you. We’ve got a lot of registered investment advisors in the audience for this webcast. So as you think about the regulatory environment heading into 2023, what are the things that RIAs should be paying most attention to?
MIKE: Yeah, it’s going to be very busy. It’s been very busy this year. I think as everyone knows the regulatory agenda, the SEC has a staggering list of initiatives. Maybe I’ll mention just a couple of broader issues and then a couple of specific ones for RIAs.
First, kind of something to watch is we expect the SEC to unveil a series of rules on equity market structure in the coming weeks. Chair Gary Gensler has talked about this in a couple of speeches recently. Among other things, the SEC is considering revising best execution rules and creating more transparency about sort of what goes on inside the pipeline between when an investor puts a trade and it disappears, and then it comes back and you kind of find out what you got. There are really concerns about where the conflicts of interest are inside that pipeline and really how does an investor even know that they got the best outcome that they should have. We’re going to be keeping an eye on that is I think that potentially has a real impact on individual investors.
And the other big issue I’m watching is, you know, the SEC has been really engaged on ESG issues, and, particularly, this big initiative to require public companies to disclose more about their climate risk and their impact on climate change. That’s super controversial. More than 15,000 comment letters have been received. I expect it’s probably going to end up in the courts. But this is part of a big effort at the SEC to be more involved in ESG issues.
For RIAs, specifically, you know, I think we’re all aware of how many things are kind of in the pipeline that are a potential impact to RIAs. We’ve got cybersecurity risk disclosure, more disclosure around how RIAs use ESG factors in their investment recommendations. There’s just a brand-new proposal at the SEC impacting how RIAs monitor and vet third parties when they outsource certain functions. I think there’s a growing concern about the burden these different rules are placing on RIAs, particularly on smaller advisors. But, unfortunately, I think that’s a trend that probably continues into 2023.
And I’d be remiss, Mark, if I didn’t say any update on the regulatory environment for RIAs would be incomplete without mentioning that the Department of Labor, the beloved Department of Labor Fiduciary Rule is likely to be back on the agenda in 2023. They have said they’re going to take another run at the dozen yearlong effort to try to define a fiduciary in the retirement savings context, and I think we will see this pop up again next year. So that’s another thing that we’ll be watching.
MARK: Thanks, Mike. Kathy, I’ve got a few Fed-related questions that I’ll send your way. The CPI Report came out last week and we know how the market reacted to it. What do you think the Fed saw when they read that point and what are they thinking about?
KATHY JONES: Yeah, I mean, it’s pretty clear the Fed pushed back on over interpreting one month’s number. You know, it was good news. I’m sure there was a sigh of relief around the Marriner Eccles building when it came out, but it was pretty clear that the market reaction to it created some story at the Fed. And so we got comments from Fed Governor Waller and a few others that, you know, ‘Everybody calm down. This is just one number. We’re still in tightening mode.’
So, you know, I think one of the issues, one of the conflicts that the Fed has, is that they want financial conditions to tighten even as inflation comes down. And that’s going to be difficult because the market is trying to look ahead and say, ‘Well, if inflation is coming down, that’s good news.’
So, again, the bottom line is what we’re looking for is pretty clear. It will be a 50-basis point rate hike in December. I think that at that point the Fed will continue to indicate that it’s in tightening mode, but maybe at a slower pace. We’re getting that subtle shift in tone. It’s not a pivot to easing, by any means, but it’s a pivot to less aggressive tightening.
MARK: Thanks, Kathy. I know you’re working on your 2023 Market Outlook, so I don’t want you to necessarily front run that, but one of the questions that came in was what do you think the Fed is going to do with respect to interest rates in 2023?
KATHY: Yeah, so our base case is the 50 basis points in December and probably another 25 in the first quarter. At that point, we don’t see them going a lot higher. The market has priced in about… pretty close to a 5% Fed Funds peak rate mid-year next year, second quarter next year. We think that’s a bit too high. Obviously, it’s going to depend on the inflation numbers and the growth numbers, but we are starting to see them… you know, a lot of indications that they’re rolling over. And I would just take into account these reasons. You know, we have long lags between the start of tightening and the impact on inflation and the economy, but that only really started tightening in earnest in about June with that 75-basis point rate hike. You know, March was just a 25-er. So we are just really on the cusp of feeling that impact. We’re already seeing interest rate-sensitive areas of the economy, like housing slow down.
A second thing is, you know, QT is… quantitative tightening is going on in the background, another source of tightening in the economy. It’s not getting much traction in terms of talk from the Fed, but that’s adding to the tightening policy. It probably reduces the need to raise rates as aggressively. We already have real interest rates at the highest level since 2008-2009. So that would be an indication that the Fed maybe has already achieved its restrictive or certainly neutral level. And then the economic data, not just here, but abroad, you know, we’re seeing that slowdown take place. So it would strike me as reasonable that the Fed could look into the first quarter of next year and say, ‘Hey, we’ve done enough for now.’
That being said, you know, there’s probably a greater chance that they overdo it than underdo it in this cycle. I think various people at the Fed have made it clear they’re modeling this off of the ‘70s inflation and the mistake there was to ease too early. So if there’s a risk to our forecast, it is that the Fed goes above and beyond what we think is reasonable and… because they’re modeling the 1970s. I think that’s probably the wrong analogy, but, you know, whatever, that’s what they seem to be doing. So that’s the risk to our outlook.
MARK: So, Kathy, you know, another risk here is the lack of liquidity that seems to have popped up in the Treasury market. All of us who were at the Schwab’s IMPACT Conference a couple weeks ago saw a few speakers talking about it, we got some questions about it. So what’s your thought? How much of a risk is that, I guess is the question?
KATHY: Yeah, there is less liquidity in the Treasury market and part of that’s due to just the undoing of some of the structures that were put in place during the pandemic. Some of that’s due to the fact that dealers simply don’t hold as much inventory as they used to and are not as willing to put that capital on the line. But I think that’s all manageable. There have been a lot of worries about the repo market, etc., etc. Between the Treasury and the Fed, I think they can manage those short-term liquidity issues.
From a longer-term perspective a lot of what we’re seeing, though, I think is the uptick in volatility. It’s not just liquidity in the Treasury market, it’s the rapidly changing forecast from the Fed. So you’re getting… we’ve had this huge, fastest rate hiking cycle in modern history, and that naturally raises volatility. It makes a lot of the bigger players step back and wonder how to position or reduce their positions.
And so to some extent, the Fed’s own aggressive policies are playing into this. If we get a calmer kind of more at least predictable path for the Fed, I think that will help the liquidity in the market because investors will feel more confident as to where they can position their portfolios.
MARK: Great, thanks. Thanks, Kathy.
Jeff, I’ve got a couple questions for you in the international arena. First one here, what actions are you seeing on the part of other central banks? We just heard from Kathy talking about the Fed. What’s the rest of the world doing?
JEFFREY KLEINTOP: Well, a pivot to rate cuts doesn’t seem likely in the near term, but central banks seem to be signaling a step down in the size of the rate hikes or even a pause. And the stock market, clearly, here, lately, has offered thanksgiving that this is an early Santa pause rally. You know, the US Fed appeared to signal a slowdown in the pace of its hikes from 75 to 50 bases points in December, and that follows the Bank of Canada stepping down from 75 to 50 in late October. Norway’s central bank stepped down from 50 to 25, as did the Reserve Bank of Australia in the last few weeks. And the central bank of one of the largest emerging market countries, Brazil, and the central bank of the largest emerging market economy in Europe, Poland, both left rates unchanged at their last meeting. So we are seeing this downshift or step down in central bank activity.
MARK: Thanks, Jeff. A couple questions on China here. It’s been kind of an outlier on various dimensions here recently. Do you think China is going to be sticking with this sort of aspirational Zero-COVID approach? And, if so, what do you think the impact on that will be to investors?
JEFF: Well, this may be the biggest risk to these signs of step downs by central bank that the market’s embraced. There are some signs that Chinese authorities are making preparations to reopen. And, in reaction, we’ve seen the MSCI China Index up 21% so far just this month. And that’s like compared to like 2- or 3% for the S&P 500. That’s huge. The markets really priced in this idea of a reopening. And China has had success containing COVID compared with the US and other countries, but that success came mainly due to China Zero-COVID policy, which mandates local authorities carry out really stringent lockdowns until no COVID cases are identified in local communities. And that had a sizable economic cost. This year, we saw that in Shanghai from April to June. And even now, cities accounting for about 50% of China’s GDP are subject to some form of social distancing and mobility restrictions.
So it’s hard to say what the drag has been, but economists… like I saw a recent report from Goldman Sachs. The economists there are expecting that COVID-related restrictions have reduced Chinese GDP by four to five percentage points. And, interestingly, for the first time in the event’s 14-year history, Alibaba decided not to disclose sales results for Singles Day, November 11th, the world’s biggest shopping day. There may have been a number of reasons for it, but I suspect it was probably because the numbers wouldn’t be great and would bring more focus on these Zero-COVID measures holding back China’s economy. But as I mentioned, this is starting to change.
There are signs of reopening after the big five-year Party Congress took place in late October. On the vaccine front, we’ve got a new inhalable vaccine that’s been approved, could be rolled out. BioNTech’s vaccine, the one in the US we call Pfizer’s vaccine, actually developed by Germany’s BioNTech, that’s been approved in China, after German Chancellor Scholz met with Xi Jinping on November 4th. And we’ve got mass local production of Paxlovid, that’s that antiviral pill, and that should begin to ramp up production shortly. That could be a game changer for China, which, previously, only used domestically developed treatments, which weren’t that effective. We’ve also got notification at the Aviation Bureau in China has increased the number of international flights over the next five months, and they’ve relaxed some quarantine requirements for inbound travelers, so that’s a sign things are opening up. And there have been several high-profile multinational events scheduled, like the Chinese government just approving and announcing the Formula One Grand Prix in Shanghai for April 16th. All that points to preparations for reopening and has driven the strong performance in Chinese stocks.
But that said, Mark, we think it’s unlikely China is going to suddenly and materially step away from its Zero-COVID protocols before the end of winter. We’ve already seen cases climbing, as we normally do this time of year. But let’s say after the Lunar New Year, after March’s two sessions, sometime late March/early April, we could start to see this reopening. If we do, it could lead to a sudden burst in pent-up spending in the world’s second largest economy of 1.4 billion consumers. That could lead to a rebound in inflation for commodities and goods. And, if so, it might come at just the point that central banks were pausing their rate hikes. I mean, stocks may welcome the boost of global growth, but worry over the potential need to extend rate hikes. And we’ll be watching these signs very carefully, and the balance between reopening euphoria and inflation worries in the stock market.
MARK: Great, thanks. Thanks, Jeff.
Liz Ann, speaking of growth, and we’ve got a lot of questions here about growth in the US, and they all seem to revolve around this question of recession. Are we either kind of in a recession right now or will we tip into one in 2023? So what are your thoughts on that?
LIZ ANN SONDERS: So there’s two questions that swirl around this whole recession debate. It’s, you know, will it become a official, when might me get the announcement from the NBER, the official arbiters, versus what are the current conditions in the economy, you know, does it feel like a recession? And the argument or the side of the debate that we’ve come down on is that I think there are already significant pockets of the economy that are in recession, and I think it’s really hard to deny that. Think of it as a rolling recession. And some on this call may remember last year we did a lot of work on and were writing about and speaking a lot about a rolling bear market that was happening under the surface of indexes that were pretty resilient last year. And that may have been a bit of foreshadowing as it relates to what’s going on in the economy this year. And I think the way to think about it is to tie it directly to the COVID environment. If you go back to the worst part of the lockdowns at the beginning of the pandemic, particularly when the massive amount of stimulus initially kicked in, particularly on the fiscal side, both to consumers directly, as well as to businesses through the PPP program, the demand that that brought about at that time was forced to be funneled into the goods side of the economy because services just were not accessible. And then, of course, exacerbated by the supply chain problems. That was the breeding ground for the inflation problem with which we’re still dealing. So you saw this burst in growth and burst in inflation driven by the goods side of the economy. That has subsequently rolled over into pent-down demand on the goods side, disinflation on the goods side of the inflation metrics, but we’ve seen that offsetting strength in services. And, in particular because services are larger employers, that has helped keep the labor market relatively healthy.
But if you look at housing, if you look at many of the call it the stay at home areas within the goods side of the economy, if you look at CEO confidence or consumer confidence, all of those are very much in recession territory. The deterioration in the leading indicators point to recession. The inversion of the yield curve, particularly all the way to the 10-year… you know, three-months/10-year Fed Funds now is indicative of a recession. But it could be spread out over a more extended period of time, as we’re still in the environment where services and relative strength in the labor market are offsetting some of those clear recessionary pockets.
Whether or not the NBER, ultimately, declares it a recession and when it started, at this point, that’s, in my mind more of an academic discussion versus some major factor driving equity market performance, given that, you know, we’re already in the bear market.
MARK: Liz Ann, I want to go back to something that Kathy said. She was talking about how the Fed speakers were, you know, kind of expressing caution about how to interpret the CPI number from last week. But from the standpoint of the stock market, the stock market seems to be acting as if inflation is over. So what is your take on that?
LIZ ANN: So I’m not surprised to see some pushback on the part of Fed speakers, and I wouldn’t be surprised to hear more of that, because we have to remember that one of the goals of the Fed in tightening monetary policy, both on the rate side and the balance sheet side, in an effort to bring down inflation, is to tighten financial conditions. And the rally we’ve seen in the stock market, coupled with the decline in bond yields, the decline in the dollar has contributed to a loosening of financial conditions. And that is similar to the environment of August, when Powell at the Jackson Hole speech opted to sort of push back against the loosening of financial conditions.
Now, the rally in the market that came off mid-June was largely predicated on this perception of a pivot. We were never in the camp that felt that there was anything resembling a green light in the near-term for the Fed to go from an aggressive rate hiking campaign to then cutting rates.
Now, this time, the rally, not just the two days that ended last week in response to the better CPI Report, but really since mid-October has had some slightly better underpinnings to it than what we saw in June. So, yes, we probably have seen the peak in inflation, but what the Fed is making very clear is that even though we know the direction or we’re pretty confident in the direction inflation being down, there’s still a pretty yawning gap between where it is right now and the Fed’s comfort zone at or closer to the 2% target.
So if financial conditions continue to loosen, I think the Fed may have to specifically push back on that, which could bring some weakness into the market because of the effect that has had on financial conditions. We also saw a huge shift from what had been a very pessimistic sentiment environment, which I think, to some degree, was the setup for what happened last Thursday and Friday, to one now that has not completely reversed, but I think watching signs of renewed froth would be a concern to me as a market watcher and I think would also indirectly be a concern to the Fed.
MARK: Jeff, kind of same question. What are your thoughts from an international perspective?
JEFF: Well, I didn’t talk about the risk to inflation, maybe renewed inflationary pressure next year as China reopens. That’s still a what-if and something we’ll keep an eye on, kind of a risk to the 2023 outlook.
As it relates to, you know, the economic picture, third quarter economic growth was better than expected for many countries in North America, like the US, Mexico. In Europe, Germany and Italy surprised definitely on the upside, no recessions there. And even in Asia, Taiwan had, what. 6.9% growth in Q3 annualized. But despite the reports of this modest growth in the third quarter as a whole, I think a global recession did begin sometime during the third quarter.
One important indicator that signaling recession is likely already underway is the leading indicator for the world economy produced by the OECD. Whenever that index dropped below 99, it’s happened around the start of a global recession. That was true in 2020, it’s true in ‘08, back in 2001, late 1990, every recession of the last 50 years. And we’re below 99 again, and that might be signaling the start of another recessionary period now underway starting maybe sometime in August or September.
And another important and widely watched indicator of recession is also signaling a similar story, and that’s the global PMI, the Purchasing Managers Index, which was below 50, that threshold between expansion and recession during the third quarter. The global composite PMI is compiled from surveys of 27,000 different businesses in 40 countries, almost 90% of GDP. So that’s a pretty good take on what’s going on, and that is also down.
Now, look, the depth of this recession appears to be mild so far. Parts of the global economy and some countries are growing, offsetting others that are contracting. For example, while there’s strength in services, just try and book an airline ticket right now, or hotel. or head over three miles from where I am right now to the Magic Kingdom and get in line for Space Mountain, it’s like 90 minutes long. But the demand in manufacturer of goods has been weakening. And we can see that in rising inventories at retailers, slowing product sales, as well, right? So we’ve got a recession rolling through different parts of the global economy at different times, in contrast to the everything everywhere, all at once recessions that we saw back in 2020, in ‘08, and ‘09.
Next, Mark, could be jobs. Corporate cash flow is weakening, at least in Europe. And in the months ahead you can see it where whenever we get free cash flow growth dropping below 5%, it tends to lead to job losses. We’re at that point now. So I’d expect in the next few months if we start to see that, that could reinforce some of the downward pressure on inflation that we’ve been seeing recently.
MARK: Thanks, Jeff.
Why don’t we turn to some strategies. And, Kathy, why don’t we start with you. Where are the opportunities right now in the bond market?
KATHY: Well, we’re seeing a lot of good opportunities in high quality bonds right now, really across a broad spectrum, from treasuries, to corporates, to munis. As I mentioned earlier, real interest rates are the highest they’ve been in over a decade. You know, and most investors buy bonds for the income, and now there’s income and fixed income again. So very attractive yields in the 4- to 6% region without extending duration, you know, beyond, say, the benchmark of the ag or the normal benchmarks around six, seven years. We haven’t seen that in a really long time. So we think that there’s opportunities really in all of those areas.
We are leaning into duration because we believe that as the Fed tightens, it brings down inflation, and that usually is good for longer term bonds. We already have an inverted yield curve and have had for quite some time. And I think even as the Fed raises rates that inversion will just deepen. And so, yeah, we’re leaning into duration in the high quality area.
MARK: Kathy, are there any particular segments where you would exercise some caution or advise people to exercise some caution before jumping in?
KATHY: Yeah, we’re still cautious on high-yield. We’re officially neutral because with the yields over 9%, it’s really hard to have a bad year when you have that kind of a starting yield looking forward. But we don’t think that the spread, the high-yield spread versus treasuries is yet at a level that discounts some of the economic pain that might come to some of these issuers. We’ve had a period where issuance is very low. A lot of these companies had been still able to continue with the financing they got six months or a year ago. But at some point, you know, if we have continued deterioration in the economic data and we get the rising rates, the refinancing in the high-yield market for some of these companies is going to be pretty difficult. So we’re avoiding high-yield, and… we’re not avoiding, but we’re limiting exposure to high-yield and bank loans for the same reason. Even though they’re short duration, that adjustment is going to work its way through pretty quickly into companies that have to refinance rapidly.
We’re still a bit cautious on emerging markets. Picture is mixed there, but generally speaking... because the dollars has come down a bit, and if we do see the Fed ease up that could be very good news for EM. Yields are attractive, but the spreads are not that wide. And, generally speaking, if Jeff is right, that we’re looking at a slower global economy, that doesn’t tend to favor outperformance by EM. So still kind of neutrally cautious there, as well.
MARK: Thanks, Kathy.
Liz Ann, let’s bring you back. You also often talk about how, you know, levels are less important than change in direction. So what are you looking at to determine whether some of the big up moves we saw in stocks last week and even today, is that indicative of an inflection point of some sort?
LIZ ANN: Possibly. So as I touched on but now I’ll provide some details, the rally, not just the latter part of last week, but off the mid-October lows, relative to what we saw in the June through August period of time, there were healthier underpinnings from a technical and breadth perspective. In fact, one of the things that happened when the market retested the June lows and actually went below the June lows, and I’m talking specifically about the S&P here, you saw what’s called a positive divergence, where the breadth conditions at the individual stock level were actually better than what they were at the mid-June lows. So that positive divergence means the indexes are taking out the prior lows, but you’re seeing less poor performance, so that inflection point, that rate of change.
You also saw specifically midweek last week... you know, Mark, even on these calls we’ve talked a bit about the difference between attitudinal measures of investor sentiment and behavioral measures of investor sentiment. We were really missing the behavioral measures, things like the put/call ratio, but with the FTX carnage, the crypto carnage mid-last week on Wednesday, you saw spike in the put/call ratio to a level we haven’t seen since the depths of the financial crisis in 2008. I also think that was a setup for what we saw Thursday and Friday, that to some degree is carrying into this week.
So I think you can at least partly check some of the boxes around sentiment, breadth and technicals. But what I think still needs to happen to get a firmer sense that the worst is behind us is at the more macro level. Stabilization in yields. Yes, I think the big move down in yields has been a support for the equity market, as is the case with the dollar, but a sense that we actually have seen stabilization there. I think we need to see, and probably will see further deterioration in PMIs, to Jeff’s points, talking globally, and a stabilization there. And I think what is still somewhat ahead of us is the deterioration in the labor market, which the Fed is actually trying to engineer some of that. I also think we need to see a stabilization in the housing market. And then maybe, most important, most connected to the stock market, I think forward earnings revisions which are still heading down, probably have more to go on the downside before we start to see a stabilization.
But notice I keep saying stabilization and not, you know, a big upshoot after that. I think it’s just that stabilization, that potential for inflection points, is what the market tends to key off more so than many of those macro conditions needing to get significantly better from here.
MARK: So given all that, where do you see the best opportunities right now in US equities?
LIZ ANN: So what we did see that was a little bit unsettling or troubling in the rally, particularly the two days last week, was, arguably, a move down the quality spectrum. Again, you saw areas and cohorts like non-profitable tech, which I put ‘tech’ in air quotes because that basket tracked by Goldman Sachs is inclusive of stocks beyond just those that live in the tech sector, but that’s generically what it’s called. You saw a reemergence in some of the meme-type stocks. I think that is part of the rally, to use a trader lingo, that you want to fade. I wouldn’t lean into lower quality areas. There are times where you want to maybe move down the quality spectrum if the market is appropriately pricing in a pretty significant lift in the economy. That was the case in late 2020 when we got the vaccine news. You move down the quality spectrum. That was where the leverage to the upside was.
I don’t think you want to lean into that in this environment, which is why we continue to emphasize quality-based investments. And we’ve really been focusing more on factors than either, you know, sectors or growth-value-style indexes. And we think that the types of factors that you want to look at are, really, they cross between both the growth side of the spectrum and the value side of the spectrum. So you want to look for positive earnings revisions, positive earnings surprises, relatively low volatility, strong free cash flow, healthy balance sheet with lots of cash and less debt, you know, dividend-payers and dividend-growers. So it’s a quality wrapper, but those are factors that span from the value side of the equation, as well as the growth side of the equation.
MARK: Thanks, Liz Ann.
Jeff, S&P 500 and MSCI’s EAFE index, they’ve dropped about the same amount this year on a year-to-date basis. What’s been driving that and do you think it will continue?
JEFF: Yeah, Mark, despite the global recession and the risk to inflation posed by China’s potential reopening next year, stepping down from aggressive rate hikes seems to be helping boost stock markets. Since signs of that stepping down began to emerge at the start of October, the EAFE Index of International Stocks is up over 15%, and it’s now in line with the S&P 500 on a year-to-date basis. I think as of yesterday’s close, EAFE was now outperforming the S&P 500 by like 30 basis points year-to-date, and that’s despite the double digit rise in the dollar this year. On a local currency basis, international stocks are outperforming the S&P 500 by 10 percentage points this year. It’s been pretty impressive.
Now, the stock markets outside the US that are outperforming the most include many countries where the central banks are stepping down, like Canada, Australia, Norway, and Brazil, for example. But the resilience of international stocks isn’t just about stepping down rate hikes. It extends from international stocks, possessing more of the characteristics or the factors, as Liz Ann talked about, that have worked across sectors and countries this year, including lower price-to-cash flow ratios, higher dividend yields. You can find all of that in greater abundance outside the US.
Also, earnings growth has been stronger outside the US this year, and that’s also helped. The year over year growth rate for earnings for S&P 500 companies in the third quarter was 4%, compared to 30% for companies in Europe’s STOXX 600 Index. And you combine that with lower valuations, that’s really helped international stocks limit their losses this year, despite all the rate hikes and the start of a global recession.
MARK: Thanks, Jeff.
Liz Ann, since you were the first one to say the magic three letters, FTX, I’ll give you this one. Do you think the FTX bankruptcy will affect other markets?
LIZ ANN: Well, to some degree, I think it has, or at least it did on Wednesday with the weakness that you saw, but then that was overshadowed by the better than expected CPI Report. But in terms of contagion, we don’t know yet. That’s the bottom line. In fact, I was watching one of the financial news programs yesterday, and they had on a regulator from the CFTC,, who was an expert in crypto and what’s coming down the pike in terms of the regulatory structure. And her comment was, when asked this question, ‘We really just don’t know at this point.’ What we started to see midweek that, again, was stalled by the rally was some margin calls. And the risk on a going forward basis is that if you continue to see the need to raise liquidity, either because of the absence of it tied into something FTX-related or margin calls, it often means you sell what you can sell, so where there is liquidity.
I also think there’s the psychological ripple effects, which maybe are lessened by virtue of the carnage that was happening during this so-called crypto winter, even in advance of the failure of FTX. You know, you were deep into drawdown mode across the crypto space and keeping with the drawdowns in other speculation-driven asset classes, like heavily shorted stocks, like the meme stocks, like the non-profitable tech, like the SPACs.
So I think the ripple effects through the confidence channels probably would have been much more severe if we weren’t already in that sort of significant drawdown mode across many of those spec areas. But to try to gauge, you know, where the counter-party risk is or where the additional liquidity risks are, I think we’re still too early in this kind of fact-finding mission.
MARK: Yep, makes sense.
Kathy, this one’s for you. Any thoughts on relative attractiveness between munis and taxable bonds for taxable investors?
KATHY: Yeah, so right now you’re getting… for people in the highest tax brackets, in general, you’re getting a bit more return in munis than you are in corporates. And you’re getting… of course, you have a universe in the municipal bonds that’s higher credit quality, on average, than in the corporate bond market. So it’s not an either/or proposition. We like both investment-grade corporates and investment-grade munis, but there’s a slight bias towards the muni side if you have a high tax bracket investor, both from a quality and from a yield point of view. It depends on where you are in the yield curve, but, in general, I would lean more towards the muni side than towards the corporate side right now.
MARK: Thanks, Kathy.
Liz Ann, this one is for you. What’s your view on valuations and future gains, and what are your thoughts on small versus large?
LIZ ANN: So, you know, the forward P/E on the S&P right now in the, you know, 17, 18 range, depending on what embedded E you’re using is still on the relatively high side. Now, one of the, I think, mistakes that a lot of investors make is not that they look back at history to gauge whether a current valuation level is reasonable or not, but they don’t take into consideration background conditions that have driven why the range around things, like historical averages, has been so wide. And one of the forces with which the market has been dealing all year, and really a sort of approximate explanation for the bear market, has to do with the aggressive Fed policy, the 40-year high in inflation. And if you look at what the average and even range of P/Es has been historically when you’re in the kind of inflation zones that we have been in and continue to be in, you’re talking about an average multiple of 11 or 12, which is, obviously, well lower than where we are.
Now, that doesn’t automatically mean that we have to descend to that. You know, in keeping with the, you know, inflection points of rate of change matter, what had been, I think a very powerful force against valuation expansion and pushing valuations down this year was the high inflation and rising interest rate environment. But if, indeed, we’re collectively correct and the peak is behind us and we’re going to continue to see descending inflation, that should take some of that downward pressure off P/E ratios. The problem is that the E, the denominator in the P/E equation on a forward basis is still in descending mode. So all else equal, that puts upward pressure on valuations. So it’s a bit of a push and pull right now.
The last thing I’d say is… not to throw out everything I just said about what drives valuation, the importance of inflation or interest rates, but, you know, we think of valuation, especially something like a P/E ratio as very quantifiable, very fundamental in nature. We know what the P/E is. We know at least what the plug is for the earnings, even if it’s on a forward basis if we use some sort of consensus number. But the reality is that valuation is as much an indicator of sentiment as it is some quantifiable tool, and there are extremes that happen in valuations that have very little to do with some of those background fundamentals and everything to do with just the psychology of the market. And I think that sometimes gets forgotten when we do valuation analysis relative to history.
MARK: Thanks, Liz Ann.
Jeff, this one is directed to you. ‘Jeff, can you please address the Ukraine/Russia conundrum and the effect on grain/food? The grain agreement was supposedly renewed at the G20 yesterday. When or will the ripple effect of Putin’s war improve?’
JEFF: Well, grain exports are continuing from Ukraine. Ukraine is a big supplier of wheat, in particular, to parts of Northern Africa, which had been suffering from very high food prices. As we know, that can be a problem for that region of the country, as it was back during the Arab Spring in the early 2010s. So it’s been something we’ve been focused on.
Fortunately, grain prices have come all the way back down. Grain, even in Northern Africa, is now back to the prices that preceded Russia’s invasion of Ukraine. So prices have come all the way back down. That’s not true for all foodstuffs, but it is related to grain prices. And so we’re seeing some of the pressure of food inflation coming down in some of the most vulnerable parts of the world.
However, we can’t yet breathe the sigh of relief. We know that there is a lag effect as it relates to urban unrest and the potential for toppling governments in those parts of the world that tend to lag, sometimes up to a year or two, when those prices of food have surged. So we’ll continue to watch it, but, you know, this wasn’t a multi-year period. This was more of a six-month period of time that we saw very elevated grain prices. So, again, we’ll keep a close eye on it.
The ripple effects seem to be fading. Energy prices have also come down. Electricity prices have come down in Europe. Though they’re not where they were two years ago, they’ve come down very dramatically from where they were this summer. And it looks like Europe has what it needs to get through the winter and prepare itself for next winter. And so the ripple effects seem to be fading. And the conflict has, you know, sort of resulted in this sort of push into the very eastern part of Ukraine where, frankly, conflict between Russian separatists and Ukrainian government has lingered for many, many, many years. So we’re almost back to where we were prior to where the invasion began. And so I’d expect the ripple effects to be fading at this point, but, of course, I don’t know what’s in Putin’s head and it could flare back up again at any time.
MARK: Jeff, here’s another question for you. ‘During the Schwab’s IMPACT Conference, Ian Bremmer said that the market was not pricing in a nuclear event provoked by Russia. What would that look like if it was priced in, or because it’s always been a threat, is it, actually, in fact, priced in?’
JEFF: Those type of geopolitical events, including the threat of some kind of nuclear strike somewhere, are an ever-present part of investing, they flare up from time to time. I don’t think we’re in one of those periods where it’s really flared up. No, the market hasn’t priced in the likelihood of a World War III, nuclear World War III, but there are several reasons for that. One, the use of a tactical nuclear weapon against Ukrainian troops really wouldn’t benefit Russia right now. Ukrainian troops are now pushed into what Russia considers its own territory, including Russian citizens. If they were to attack those troops there, not only would it affect Russian citizens and Russian territory, the fallout would likely blow into Russia’s formal territorial borders, itself. So it would be self-defeating. A number of other reasons, as well. France has come out and made it clear they would not view a nuclear attack in Ukraine as something that would prompt a nuclear response by them, and the US administration has been fairly clear on that front as well, saying they can’t see a development inside Ukraine that would prompt a nuclear strike by the US.
So it seems like the market is probably wisely putting this down at that low level that always exists in the marketplace as the potential for some type of threat, but not seen as particularly heightened right now, despite Putin’s bluff of a couple of months ago.
MARK: Thanks, Jeff.
Liz Ann, this one is directed to you. ‘Can Liz Ann discuss the Fed’s 2% target for inflation? It seems a bit arbitrary. Why 2%? It seems possible with change in Fed members in the future that could change this arbitrary target. Is that possible? And, if so, what would be the impact on the markets?’
LIZ ANN: So, yes, I suppose it’s possible. There’s also the possibility that even if there’s not some sort of formal change to the 2% target via the process of jawboning, which the Fed is pretty good at, they could start to signal that, you know, perhaps… this is just more of an example, not so much a speculation that this is what they’re going to do, but if inflation gets down below the 3%, so has a, you know, 2-handle on it, there could be commentary suggesting that at least directionally they’re getting closer to that comfort zone.
So I wouldn’t be surprised if you start to hear some comments from the Fed that it really isn’t a goal to bring whatever it is, PCE, core PCE, which is still their preferred measure, versus CPI, which has been running a bit hotter because of the shelter components, but when we get closer to that point, they may suggest that their comfort level has increased. But a formal change to the language, I don’t think something like that happens officially at this point in the cycle.
MARK: Thanks, Liz Ann.
Kathy, what impact do you think that would have on the bond markets?
KATHY: Well, I would agree with Liz Ann, I don’t think it’s going to happen. The Fed has had that 2% inflation target for a very long time, since the 1990s. There was talk about, you know, trying to make it symmetrical, which that was a shift that was made pre-pandemic, pre-inflation, where the Fed said, ‘Well, you know, we’ve been undershooting for so many years, we should allow for a little bit of overshooting to get to the average.’ But, frankly, there’s been no talk about that. It seems highly unlikely to me that the Fed, particularly a Fed that’s obsessed with its place in history in fighting inflation would change that. So I think it’s not likely to happen. You know, they could… sure, as inflation comes down, they will probably ease up in terms of tightening. That would make sense, so as not to undershoot too much. But I don’t think changing that target is going to happen. That’s been in place since the ‘90s under Greenspan.
MARK: Thanks, Kathy.
So why don’t we wrap things up here with one final question for each of you. We’ll start out with you, Mike. What are the three things you want viewers to take away from your thinking today?
MIKE: Sure. Number one, you know, with a likely split Congress and razor thin majorities in both the House and the Senate, hard to see how major legislation gets through next year. Certainly, things on the scope of the Infrastructure Bill or the Inflation Reduction Act seemed very unlikely. So look, you know, for smaller issues where that could be bipartisan compromise, and look for regulators to step in and be very aggressive next year.
Number two, what to watch in the next couple of weeks is, you know, what happens with the Secure Act 2.0. I think there’s a really good chance that that could pass before the end of the year. And the other piece of that is watch what happens with this possible debt ceiling resolution. I think it’s a long shot, but I think it’s really interesting that a lot of prominent Democrats are really pushing for a debt ceiling solution here before the end of the year.
And, number three, I think RIAs should continue to expect a flurry of regulation. Some of these proposals are going to get resolved in the months ahead and probably going to be more work for RIAs. So it’s something to continue to watch.
MARK: Thanks, Mike.
Liz Ann, what are the three takeaways from your remarks?
LIZ ANN: So I’d say that with regard to Fed policy and the economy, I talked about the notion of a rolling recession that so far, anyway, we’ve not seen significant deterioration in the labor market. But we have to remember that the Fed is actively trying to weaken the labor market. So a weaker labor market is a feature of what the Fed is doing, not a bug in what the Fed is doing. So I think that is still yet to come.
From a market perspective, as I mentioned, I think sentiment started to look better, as did breadth and technicals, but I don’t think we’re out of the woods yet in terms of some of those macro conditions that need to at least find an inflection point, stop getting worse in advance of getting better. In other words, you know, better or worse matters more than good or bad, as you suggested.
And then just oriented toward factor-based investing. It’s in the context of an environment where active management is operating on a more level playing field relative to passive, really, than what we’ve seen in quite a few years. Equal weight is outperforming cap weight. And I think that provides opportunities for advisors working with their clients.
MARK: Thank you, Liz Ann.
Jeff, you’re up next.
JEFF: Well, the global recession has prompted central banks around the world to begin to step down their rate hikes. But China’s potential reopening presents an upside risk to inflation and could mean a pause in hikes gets delayed. That’s a risk, not a base case. Something to watch out for.
Quality factors and international stocks continue to be attractive areas, performing well on the downside in the first three quarters of the year, and now again in the fourth quarter rally, Mark.
MARK: Thank you, Jeff.
And, Kathy, we’ll give you the last word today.
KATHY: Okay. I guess the three things I would put out, first, is just avoid recency bias. Last year, or this year, has been a terrible year in fixed income, but we’re really optimistic that we’re set up for a good year. A lot of clients, obviously, concerned about bond allocations after a bad year, but with the coupon income so much higher, yields so much higher, the prospects for positive returns are much better.
I think the second thing is just keep in mind if the Fed continues to tighten, that actually is bullish for the long end of the bond market. You don’t have to wait, and, historically, it’s not a great idea to wait until the Fed is done tightening to start adding duration, because usually by then yields are coming down. And, in fact, we already have a very inverted yield curve, which is normal in this sort of process.
And then, finally, we do favor taking duration risk over credit risk in this environment.
MARK: Thank you, Kathy.
And we are out time. So Mike Townsend, Kathy Jones, Jeff Kleintop, Liz Ann Sonders, thanks for your time today. If you’re interested in revisiting this webcast, we will be sending out a follow up email with a replay link. And if you’re interested in receiving continuing education credit, live attendance and only live attendance will make you eligible for one hour of CFP and/or CIMA continuing education credit. If you watch the replay, you aren’t eligible for the credit. When you registered for the webcast, if you sent your ID number in, we’ll take care of that, submitting it on your behalf. If you didn’t enter your number at registration, there should be a box at the bottom of your screen where you can type that in. And make sure you specify whether it’s for the CFP or the CIMA board. Finally, if you can also download a CFP or CIMA certificate for your own records.
The next installment of this series will be on December 13th at 8:00 AM. Mike, Liz Ann, Jeff, and Kathy will be back. The theme of that will be our 2023 Market Outlook episode. And we’ll do it a little bit differently. Each presenter will take about 10 minutes or so to do about a 10-minute presentation with slides on their areas of expertise.
Until then, if you’d like to learn more about Schwab’s insights or other services, just please reach out to your Schwab representative. Thanks for your time today, and have a nice day.